So you’ve gone to the market and decided to buy some tasty fruit. You see you only have $10 so you’ll buy using $5 apples and $5 bananas. Usually, bananas tend to be more expensive than apples which means you’ll get two bananas and eight apples for the same amount of $5 each.
When you go home, you decide to put your fruit together in a basket with your roommates – you can imagine that basket as being a liquidity pool. Your roommates add an equal number of apples and bananas as you.
As time goes by, the price of bananas goes up, due to high demand. The landlord is in charge of the fruit basket – he is the arbitrageur. When he sees the price difference between your basket and the market, he decides to add more apples to the basket to keep its value.
If you decided to keep the fruit in the basket despite the price change of bananas, you would have $15 worth of fruit.
Seeing these changes, you now want to take your fruit back – after all, you paid for them. But, if you decide to withdraw them now, you will only get back one banana and twelve apples now worth $12. Naturally, this would mean you would experience permanent loss.
The difference between the $15 worth of fruit kept in the basket and the $12 worth of fruit if you decided to take them back represents impermanent loss as the $3 that you allegedly lost was lost only on paper and over time, the ratio could return to the original amount of apples and bananas.
We hope you haven’t gone bananas yourself trying to keep up … it’s not a terribly difficult concept if you think about it a bit.
How Do We Characterize Impermanent Loss?
The idea of impermanent loss reflects the temporary loss of a part of the liquidity that you own.
The phenomenon occurs within liquidity pools, where the liquidity provider must include proportional amounts of 2 different tokens.
If one of the tokens is more requested, then the proportion of the two assets in the pool changes.
In case the provider now decides to withdraw their assets from the liquidity pool, they risk not recovering the entire amount and in the proportion in which they have deposited it.
If this happens, that impermanent loss turns into a permanent loss.
This is basically what we said in our fruit example. The tokens were the fruit and the basket was the liquidity pool.
We hope you are interested in today’s subject so if you have any other questions about Impermanent Loss, don’t be shy, go ahead and ask them in the comment section. We are here to answer and help, and in the following example we will practically explain a practical case of impermanent loss.
Practical Case of Impermanent Loss
How Two Assets Equate in a Pool
To support the funds of an AMM, Jonathan deposits 1 ETH and 100 DAI in a liquidity pool of an AMM, at a 50/50 ratio.
The amounts of the deposited tokens must have an equivalent value.
In the case described, this means that the price of 1 ETH is exactly 100 DAI at deposit time.
Also, let’s say that the current total dollar value of Johnathan’s deposit is $200.
If the total in that pool (also supported by other providers) is 10 ETH and 1,000 DAI, Jonathan holds a 10% share of the fund, and the total liquidity is 10,000.
This total liquidity of 10, 000 is a number and actually represents a constant which is given by the AMM/s equation set by the creators of the exchange contract.
The equation’s result is obtained by multiplying the number of tokens 1 in that pool with the number of tokens 2. In this case, since we have a total of 10 ETH multiplied by 1000 DAI, the total liquidity constant is 10 000.
Since Jonathan holds 10% of the shared fund, does that make him rich? That’s not the point, focus on the main info of what we’re giving.
How Does Impermanent Loss Occur?
Getting back to our story … In this case, let’s suppose that the ETH price increases to 400 DAI.
If this happens, arbitrage trading strategies will add DAI to the pool and remove ETH until the ratio reflects the current price.
Since AMMs don’t work with order books, the price of the assets is given by their ratio in the pool.
In short, if the liquidity remains constant in the fund (remember the 10,000 constant), the ratio of the assets in it changes.
This could very well be a real-life example as ETH does cost more than DAI – much more.
How Many Funds Does the Provider Get?
If ETH has come to be 400 DAI, the ratio of the existing ETH and DAI amounts in the pool has changed.
There are now 5 ETH and 2,000 DAI in common, but if Jonathan decides to withdraw his funds, he is entitled to 10% of that pool.
So, he can only withdraw 0.5 ETH and 200 DAI, totaling $400.
Although profits of $200 resulted, the amount would have been different if he had just continued to hold 1 ETH and 100 DAI without locking them up inside the pool.
The combined dollar value of these assets would now have been $500 on the market.
So Jonathan should have learned the ABCs of investing before pulling this stunt. Just like with the crypto market in general in this case you also need to learn that a change doesn’t mean you have to sell or get back your assets. Sometimes it is better to just go with the market flow.
It’s true that our example doesn’t take into consideration the trading fees that the provider can earn – in some instances, the earned fees could end up canceling losses and actually make supplying liquidity profitable.
We don’t know if Jonathan was rich when he became involved in this, but he is richer now. And we do know he could have been richer if he held onto his assets. Don’t be like Jonathan …